Innovation in financial products has been a core guiding principle within the capital markets for centuries. In many ways, the history of derivatives is the history of capital markets is the history of innovation in financial engineering.

From tulip futures and options, through to swaps and swaptions, and collateralized debt obligations, banks on the sell side have continually sought ways to leverage assets and locate factor-specific alpha. This has largely been in service of a buy side with an ever-increasing appetite for highly specialized risk-taking and funding across the financial market.

Such innovative financial engineering has fuelled the growth of the derivatives market to its current level of over $550 trillion. It is not surprising, in the aftermath of the last credit/liquidity crisis that regulators globally would try to control the risks that this largely opaque, over-the-counter market presents. Their attempts have consisted of three parts:

  • Increase capital/collateral, relative to counterparty exposures, by adopting value-at-risk-based collateral calculations and pricing in the difference in credit worthiness between traders via the credit valuation adjustment/funding valuation adjustment.
  • Centralize clearing of the most common derivative types (swaps and CDS) to reduce the systemic risk of any individual market participant and enforce an increased margin requirement on each trader.
  • Separation of the trading and core banking businesses under the Volcker Rule within regulated banks.

There is no reversing the rich regulatory tapestry underpinning today's financial markets, which is interwoven with many specific rules and measures such as wrong-way risk, single counterparty limits and liquidity coverage ratios. But the ultimate battle plan of U.S. regulators involves stripping away the high-level specifics to increase the capital and collateral held against complex contracts, standardizing clearing and insulating the core banking function from risks associated with trading.
The (possibly) unintended consequence of this approach has been to reduce the risk appetite of the sell side overall. Unfortunately, reducing risk appetite among the larger banks does not remove the need for financial innovation.

The last financial crisis was just one hit absorbed by the buy side. The pension fund community, in particular, has seen lowering returns from equity markets and very low bond yields over the last decade. This has amplified the stress such funds have been under from the general trend of increasing pensioner longevity. Under-funded pools required to return higher yields than expected in historically low performance markets is a situation that cries out for financial engineering and innovation. Funds whose mandates have restricted use of non-traditional assets are changing their risk policies at the board level in search of growth and yield.

It's not simply the funded ratio of the pension funds. The same underlying rationale is forcing wealth managers to look for higher yields as their clients demand more from their tertiary investment vehicles. The buy side, in general, has a need for active, liquid markets to provide robust pricing and market transparency.

The end result is that this market evolution is fueling innovation. Central clearing of derivatives provides a bridge from the buy and sell side to a different-looking financial landscape of regulated and unregulated firms, at least as far as the core banking regulators are concerned. It is, of course, impossible to predict exactly where the onus of liquidity and innovation will ultimately fall, but it is possible to look at incentives and behaviors, which point in the likely direction.

If the larger banks retreat from being liquidity/innovation providers, then the asset managers and pension funds will need to look elsewhere. The most likely areas would be the broker-dealer community, as their interest in providing market liquidity and financial innovation is very much in line with the needs of the underlying asset managers they serve. To that end, there is an observed trend of chief risk officer appointments and risk-landscaping within broker-dealers.

It is also clear, from the market activity around risk management within the larger pension funds that they are becoming pioneers of innovation rather than simply being consumers of innovation. As noted, the funding position and demographics facing the pension funds make this entirely consistent with the overall financial terraforming.

On a related note, the risk management traditionally undertaken within banks has been to determine regulatory capital levels, and, as such, has often been seen as secondary to the actual trading. Pension funds tend to see their risk management as an integral part of their portfolio management strategy, as they are looking to use the mathematical techniques underpinning the risk numbers, to more accurately gain leverage to increase funding levels and returns.

Financial innovation is not new on the buy side, with some pension funds, insurance companies and hedge funds leading the charge for many years. But the balance between the buy and sell side is definitely shifting. The emerging innovation and associated risk management is now increasingly moving away from the large Wall Street banks, which are reducing their risk-taking and associated costs significantly.

New innovation spells interesting times ahead for financial engineers, liquidity and innovation consumers and providers, but perhaps most of all for risk managers. They are the ones who will be faced with measuring and monitoring risks coming from more opaque sources, while struggling to keep up with their internal bank regulations. This will require an agile approach to what risk is and how to achieve the balance between regulatory, credit and market risk for innovation to help drive competitive advantage from compliance.

Marcus Cree is vice president of risk solutions for capital markets at SunGard, a global software and technology services company.